Special Acquisitions: Financing A Business with Debt Chapter 8 Special Acquisitions: Financing A Business with Debt Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Business Background Capital structure is the mix of debt and equity used to finance a company. DEBT: Loans from banks, insurance companies, or pension funds are often used when borrowing small amounts of capital. Bonds are debt securities issued when borrowing large amounts of money. Can be issued by either corporations or governmental units. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Notes Payable and Mortgages When a company borrows money from the bank for longer than a year, the obligation is called a long-term note payable. A mortgage is a special kind of “note” payable--one issued for property. These obligations are frequently repaid in equal installments, part of which are repayment of principal and part of which are interest. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company How Borrowing Money With A Long-term Note Affects The Accounting Equation When the note is issued (when the money is borrowed): Assets = Liabilities + OE + cash = + N/P Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company How Borrowing Money With A Long-term Note Affects The Accounting Equation When a payment (that is MORE than the interest) is made: Assets = Liabilities + OE -cash -N/P - interest expense (a little part) (for the period) Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Example: Borrowing To Buy Land By Using A Mortgage ABC Co. signed a $100,000, 3 yr. mortgage (for a piece of land) which carried an 8% annual interest rate. Payments are to be made annually on December 31 of each year for $38,803.35. What is the amount of the liability (mortgage payable) after the first payment is made? Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Example continued... For Yr.1, the outstanding amount borrowed is $100,000 (at 8%), so the interest is: $8,000 Payment is $38,803.35, so the amount that will reduce the principal is $30,803.35 New outstanding principal amount is $100,000 - 30,803.35 = $69,196.65 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Amortization Schedule Principle Balance Reduction in Principle Payment Interest 100,000.00 38,803.35 38,803.35 38,803.35 8,000.00 38,803.35 5,535.73* 33,267.62 69,196.65 2,874.32** 35,929.03 35,929.03 *69,196.65 x .08 **35,929.03 x .08 = 2,874.32 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Time Value of Money The example of the mortgage demonstrates that money has value over time. When you borrow $100,000 and pay it back over three years, you have to pay back MORE than $100,000. Your repayment includes interest--the cost of using someone else’s money. A dollar received today is worth more than a dollar received in the future. The sooner your money can earn interest, the faster the interest can earn interest. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Interest and Compound Interest Interest is the return you receive for investing your money. You are actually “lending” your money, so you are paid for letting someone else use your money. Compound interest -- is the interest that your investment earns on the interest that your investment previously earned. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Future Value of a Single Amount How much will today’s dollar be worth in the future? ? TODAY FUTURE Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company If You Deposit $100 In An Account Earning 6%, How Much Would You Have In The Account After 1 Year? PV = FV = 100 106 1 n:i% = 6 PV = 100 N = 1 FV = 100 * 1.06 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company If You Deposit $100 In An Account Earning 6%, How Much Would You Have In The Account After 5 Years? PV = 100 FV = 0 5 Using a future value table i% = 6 PV = 100 n = 5 FV = 100 * (factor from FV of $1 table, where n = 5) Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company If You Deposit $100 In An Account Earning 6%, How Much Would You Have In The Account After 5 Years? PV = 100 FV = 0 1 n:i% = 6 PV = 100 N = 1 FV = 100 * 1.3382 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company If You Deposit $100 In An Account Earning 6%, How Much Would You Have In The Account After 5 Years? PV = FV = 133.82 100 0 1 n:i% = 6 PV = 100 N = 1 FV = 100 * (factor from FV of $1 table, where n = 5) Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company The Value of a Series of Payments The previous example had a single payment. Sometimes there is a series of payments. Annuity: a sequence of equal cash flows, occurring at the end of each period. When the payments occur at the end of the period, the annuity is also known as an ordinary annuity. When the payments occur at the beginning of the period, the annuity is called an annuity due. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company What An Annuity Looks Like 1 2 3 4 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Example If you borrow money to buy a house or a car, you will pay a stream of equal payments. That’s an annuity. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Future Value of an Annuity If you invest $1,000 at the end of the next 3 years, at 8%, how much would you have after 3 years? 0 1 2 3 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Future Value of an Annuity If you invest $1,000 at the end of the next 3 years, at 8%, how much would you have after 3 years? 0 1 2 3 1,000 1,000 1,000 n = 3 i = 8% Pmt. = 1,000 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Future Value of an Annuity If you invest $1,000 at the end of the next 3 years, at 8%, how much would you have after 3 years? 0 1 2 3 1,000 1,000 1,000 FVA = 1,000 * [value from FVA table, 3yrs. 8%] FVA = 1,000 * 3.2464 = $3,246.40 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Future Value of an Ordinary Annuity (Annuity in Arrears) In the previous example, notice that the last payment is deposited on the last day of the last period. That means it doesn’t have time to earn any interest! This type of annuity is called an ordinary annuity, or an annuity in arrears. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Future Value of an Annuity Due Often, when the series of payments applies to money saved, an annuity due is a better description of what happens. Suppose you decide to save $1,000 each year for three years, starting TODAY! Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Future Value of an Annuity Due If you invest $1,000 at the beginning of each of the next 3 years, at 8%, how much would you have after 3 years? Future value 0 1 2 3 1,000 1,000 1,000 Today FVA = 1,000 * [value from FVADue table, 3yrs. 8%] FVA = 1,000 * 3.50611 = $3,506.11 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Present Value of a Single Amount How much is $1 received in the future worth today? (COMPOUNDING) Figuring out how much a future amount is worth TODAY is called DISCOUNTING the cash flow. ? TODAY FUTURE Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company If you will receive $100 one year from now, what is the PV of that $100 if the relevant interest rate is 6%? PV = FV = 100 0 1 ioi% = 6% N = 1 FV = 100 PV = ?? Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company If you will receive $100 one year from now, what is the PV of that $100 if the relevant interest rate is 6%? PV = 94.34 FV = 100 0 1 PV (1 + 0.06) = 100 (which is the FV) PV = 100 / (1.06)1 = $94.34 OR PV = FV (PV factor i, n ) PV = 100 (0.9434 ) (from PV of $1 table) PV = $94.34 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company The Value of a Series of Payments The previous example had a single payment. Sometimes there is a series of payments. Annuity: a sequence of equal cash flows, occurring at the end of each period. When the payments occur at the end of the period, the annuity is also known as an ordinary annuity. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Present Value of an Annuity Finding the present value of a series of cash flows is called discounting the cash flows. What is the series of future payments worth today? 1 2 3 4 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company What is the PV of $1,000 at the end of each of the next 3 years, if the interest rate is 8%? 1000 1000 1000 0 1 2 3 i% = 8 N = 3 PMT = 1,000 PV = ?? Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company What is the PV of $1,000 at the end of each of the next 3 years, if the interest rate is 8%? Present Value 1000 1000 1000 0 1 2 3 PVA = 1,000 (3 yrs., 8% factor from the PVA table) PVA = 1,000 * (2.5771) PVA = $2,577.10 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Tables Versus Calculator REMEMBER -- The tables have a discrepancy due to rounding error; therefore, the calculator is more accurate. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Hint for Single Sum Problems In every single sum future value and present value problem, there are 4 variables: FV, PV, i, and n When doing problems, you will be given 3 of these variables and asked to solve for the 4th variable. Keeping this in mind makes “time value” problems much easier! Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Hints for Annuity Problems In every problem, there are usually 3 amounts given: (1) amount of the cash flow, (2) interest rate (i%), and (3) the number of payments (n). First, determine if the annuity is an ordinary annuity (payments at the end of the period) or an annuity due (payments at the beginning of the period). Most calculators are programmed for ordinary annuities. Then, determine if you want the PRESENT value of the payments or the FUTURE value of the payments. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Characteristics of Bonds Payable Bonds usually involve the borrowing of a large sum of money, called principal. The principal is usually paid back as a lump sum at the end of the bond period. Individual bonds are often denominated with a par value, or face value, of $1,000. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Characteristics of Bonds Payable Bonds usually carry a stated rate of interest. Interest is normally paid semiannually. Interest is computed as: Interest = Principal × Stated Rate × Time Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Bonds This is the information shown on a bond certificate... $1,000--principal 10%--interest rate (annual) 5yrs.--time to maturity annual---interest payments The cash flows associated with the bonds are defined by the terms on the face of the bond. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Characteristics of Bonds Payable The new bondholder receives a bond certificate. Identifies the par value, the stated interest rate, the interest dates, and the maturity date. The trustee makes sure the issuing company fulfills all of the provisions of the bond indenture, or agreement. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Bond Classifications Unsecured bonds (also called debentures) do not have pledged assets as a guarantee of repayment at maturity. Secured bonds include a pledge of specific assets as a guarantee of repayment at maturity. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Bond Classifications Ordinary bonds (also called single-payment bonds) The full face amount is paid at the maturity. Serial bonds The principal is paid in installments on a series of specified maturity dates. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Bond Classifications Callable bonds May be retired and repaid (called) at any time at the option of the issuer. Redeemable bonds May be turned in at any time for repayment at the option of the bondholder. Convertible bonds May be exchanged for other securities of the issuer (usually shares of common stock) at the option of the bondholder. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Bond Classifications Registered bonds Payment of interest is made by check and mailed directly to the bondholder whose name must be registered. Coupon bonds Coupons are attached to the bond for each interest payment. The bondholder “clips” each coupon and presents it for payment on the interest date. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Measuring Bonds Payable and Interest Expense The selling price of the bond is determined by the market based on the time value of money. Today Future . . . principal payment dates of interest payments Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Measuring Bonds Payable and Interest Expense The interest rate used to compute the present value is the market interest rate. Also called yield, effective rate, or true rate. Creditors demand a certain rate of interest to compensate them for the risks related to bonds. The stated rate, or coupon rate, is only used to compute the periodic interest payments. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Who Would Buy My Bond? $1,000, 6% stated rate. The market rate of interest is 8%. Who would buy my bond? Nobody---so I’ll have to sell (issue) it at a discount. e.g., bondholders would give me something less for the bond. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Who Would Buy My Bond? $1,000, 6% stated rate. The market rate of interest is 4%. Who would buy these bonds? EVERYONE! So the market will bid up the price of the bond; e.g., I’ll get a little premium for it since it has such good cash flows. Bondholders will pay more than the face. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Determining the Selling Price Bonds sell at: “Par” (100% of face value) less than par (discount) more than par (premium) Market rate of interest vs. bond’s stated rate of interest determines the selling price (market price of the bond) Therefore, if market % > stated %: Discount market % < stated %: Premium Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company The time value of money... Selling price of a bond = present value of future cash flows promised by the bonds, discounted using the market rate of interest Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Finding The Proceeds Of A Bond Issue To calculate the issue price of a bond, you must find the present value of the cash flows associated with the bond. First, find the present value of the interest payments using the market rate of interest. Do this by finding the PV of an annuity. Then, find the present value of the principal payment at the end of the life of the bonds. Do this by finding the PV of a single amount. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Selling Bonds -- Example On May 1, 1991, Clock Corp. sells $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years, and interest is paid semiannually. The market rate is 8% annually. Determine the proceeds from this bond issue. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

First, what are the cash flows associated with this bond? Interest payments of $60,000 (that’s 6% of the $1 million face value) each year for 10 years. AND A lump sum payment of $1,000,000 (the face amount of the bonds) in 10 years. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

The PV of the future cash flows = issue price of the bonds The present value of these cash flows will be the issue price of the bonds. That is the amount of cash the bondholders are willing to give TODAY to receive these cash flows in the future. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Two parts to the cash flows: PRINCIPAL PAYMENT PV of a single amount of $1 million ten years in the future at 8%: Use a calculator or a PV of a single amount table: 1,000,000 (PV,,8%, 10) = 1,000,000 (.46319)= 463,190 INTEREST PAYMENTS PV of an ordinary annuity of $60,000 for 10 periods at an interest rate of 8%: Use a calculator or a PV of an annuity table: 60,000 (PVA,,8%, 10)= 60,000 (6.7101) = 402,606 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Selling Bonds -- Example The sum of the PV of the two cash flows is $865,796. The bonds would be described as one that sold for “87.” We’ll round to a whole number just to make the example easier to follow. What does that mean? It means the bonds sold for 87% of their par or face value. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Selling Bonds -- Example If the bonds sold for 87% of their face value, the proceeds would be approximately $870,000 (rounded) for $1,000,000-face bonds. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Recording Bonds Sold at a Discount The balance sheet would show the bonds at their face amount minus any discount. The discount on bonds payable is called a contra-liability, because it is deducted from the liability. Cash would be recorded for the difference, that is, the proceeds. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Recording Bonds Sold at a Discount This is how the issue of the bonds would affect the accounting equation: Assets = Liabilities + Owners’ Equity + 870,000 cash +1,000,000 bonds payable ( 130,000) discount on bonds payable Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Selling Bonds -- Example On May 1, 1991, Magic Inc. sells $1,000,000 in bonds having a stated rate of 9% annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 8% annually. Determine the issue price of these bonds. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Selling Bonds -- Example To figure out the proceeds from the sale, you either have to calculate the present value of the cash flows (using the market rate of interest) OR Be told that the bonds sold at X, a percentage of par (e.g., 104). Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

First, what are the cash flows associated with this bond? Interest payments of $90,000 (that’s 9% of the $1 million face value) each year for 10 years. AND A lump sum payment of $1,000,000 (the face amount of the bonds) in 10 years. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

The PV of the future cash flows = issue price of the bonds The present value of these cash flows will be the issue price of the bonds. That is the amount of cash the bondholders are willing to give TODAY to receive these cash flows in the future. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Two Parts To The Cash Flows PRINCIPAL PAYMENT PV of a single amount of $1 million ten years in the future at 8%: Use a calculator or a PV of a single amount table: 1,000,000 (PV,,8%, 10) = 1,000,000 (.46319) = $ 463,190 INTEREST PAYMENTS PV of an ordinary annuity of $90,000 for 10 periods at an interest rate of 8%: Use a calculator or a PV of an annuity table: 90,000 (PVA,,8%, 10)= 90,000 (6.7101) = $ 603,909 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Bonds Issued At A Premium The total PV of the two cash flows is $1,067,099. This is more than the face, so these bonds are being issued at a premium. Again, we’ll round the number to make the example easier to follow. Let’s say these bonds were issued at 107, or 107% of par. That would make the proceeds $1,070,000 (rounded). Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Recording Bonds Sold at a Premium The bonds payable will be recorded at the face value of $1 million. The excess of the proceeds over the par value will be recorded in another liability account called premium on bonds payable. Together, these two amounts equal the book value or carrying value of the bonds. Assets = Liabilities = Owners’ Equity $1,070,000 cash $1,000,000 bonds payable 70,000 premium on bonds payable Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Measuring and Recording Interest on Bonds Issued at a Discount The discount must be amortized over the outstanding life of the bonds. The discount amortization increases the periodic interest expense for the issuer. Two methods are commonly used: Effective-interest amortization Straight-line amortization Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Recall the Facts of the Problem Clock corp. Sold their bonds on may 1, 1991 at 87. The bonds have a 10-year maturity and $30,000 interest is paid semiannually. Why would the bonds sell for 87? The market rate of interest was greater than the rate on the face on the date of issue. So clock corp. Had to offer the bonds at a “discount” to get buyers. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Problem, Continued Clock Corp. sold their bonds on May 1, 1991 at 87. The bonds have a 10-year maturity and $30,000 interest is paid semiannually. Where did the $30,000 come from? 1,000,000 x .06 x 1/2 The interest payments are always calculated by the terms and amounts stated on the face of the bonds. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Method For Amortizing A Bond Discount If we prepared a balance sheet on the date of issue, the bond would be reported like this: Bonds Payable $ 1,000,000 less Discount on B/P (130,000) Net Bonds Payable 870,000 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Method For Amortizing A Bond Discount The discount is a contra-liability (and is deducted from the face value of the bond to give the “book value.”) In order to get the book value to equal the face value at maturity, we’ll have to get rid of the balance in the discount account. Each time we pay interest to our bondholders, we’ll amortize a little of the discount. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Method For Amortizing A Bond Discount Each time we pay interest to our bondholders, we’ll amortize a little of the discount--how much? On the first interest date, the amount we’ve actually “borrowed” from the bondholders is $870,000. The market rate at the time we borrowed--the rate we had to pay to get the bondholders to buy our bonds--was 8%. 870,000 x .08 x 1/2 = 34,800 (This will be the interest expense for the first 6 months.) Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Amortization of Bond Discount We know the cash payment to the bondholders is $30,000: 1,000,000 x .06 x 1/2 par value interest 6-month period rate Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Amortization of Bond Discount The difference between the interest expense of $34,800 and the cash payment to the bondholders of $30,000 is the amount of discount amortization. $34,800 - 30,000 $ 4,800 This amount will be deducted from the discount. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Next Time -- When we calculate the amount of interest expense for the second interest payment, our principal balance has changed. Instead of 870,000, we now have a principal balance of 874,800. Why? 874,800 x .08 x 1/2 = $34,992 This is the interest expense for the second six-month period. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Amortization of Bond Discount interest expense $34,992 cash payment 30,000 discount amortization 4,992 After this payment, the new book value of the bonds will be 874,800 + 4,992 = $879,792. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Amortization of Bond Discount Carrying value of bonds is defined as the par or face value of the bonds minus any unamortized discount (or plus any unamortized premium). In this example, the discount has now been reduced from 130,000 to 120,208. The carrying value of the bonds is the face ($1,000,000) minus the unamortized discount ($120,208) = $879,792. The book value of the bonds is increasing. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company What’s Happening? Each time we pay the bondholders $30,000, we are not paying the full amount of the true interest expense for the $870,000 loan. The amount we don’t pay gets added to the carrying value of the bond. (Reducing the discount increases the carrying value of the bond.) So, the bond’s carrying value is increasing from $870,000 to the face value of $1,000,000 over the life of the bond. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Straight-Line Amortization of Bond Discount The other method is not as accurate, but the calculations are easier. Identify the amount of the bond discount. Divide the bond discount by the number of interest periods. Include the discount amortization amount as part of the periodic interest expense entry. The discount will be reduced to zero by the maturity date. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Straight-Line Amortization of Bond Discount Here’s a review of the facts of the problem: Clock Corp. sold their bonds on May 1, 1991 at 87. The bonds have a 10-year maturity and $30,000 interest is paid semiannually. Why would the bonds sell for 87? The market rate of interest is greater than the rate on the face. Where did the $30,000 come from? 1,000,000 x .06 x 1/2 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Straight-Line Amortization of Bond Discount The discount of $130,000 is divided by 20. (10-year bonds with interest paid twice each year) $6,500 will be amortized from the discount every time the interest payment is made. So, interest expense will be $36,500 every time the $30,000 payment is made. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Measuring and Recording Interest on Bonds Issued at a Premium The premium must be amortized over the term of the bonds. The premium amortization decreases the periodic interest expense for the issuer. Two methods are commonly used: Effective-interest amortization Straight-line amortization Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Recall the Facts of the Problem Magic Inc. sold their bonds on May 1, 1991 at 107. There were $1,000,000 worth of bonds with a stated rate of 9% annually. The bonds mature in 10 years and $45,000 interest is paid semiannually. The market rate is 8% annually. Why would the bonds sell for 107? The market rate of interest is less than the rate on the face. Where did the $45,000 come from? $1,000,000 x 9% x 1/2 = 45,000 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Method For Amortizing A Bond Premium If we prepared a balance sheet on the date of issue, the bond would be reported like this: Bonds Payable $ 1,000,000 plus Premium on B/P 70,000 Net Bonds Payable $1,070,000 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Method For Amortizing A Bond Premium The premium carries a credit balance (and is added to the face value of the bond to give the “book value.”) In order to get the book value to equal the face value at maturity, we’ll have to get rid of the balance in the premium account. Each time we pay interest to our bondholders, we’ll amortize a little of the premium. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Method For Amortizing A Bond Premium Each time we pay interest to our bondholders, we’ll amortize a little of the premium--how much? On the first interest date, the amount we’ve actually “borrowed” from the bondholders is $1,070,000. The market rate at the time we borrowed--the rate we had to pay to get the bondholders to buy our bonds--was 8%. The face rate is 9% 1,070,000 x .08 x 1/2 = 42,800 (This will be the interest expense for the first 6 months.) Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Method For Amortizing A Bond Premium If we pay the bondholders $45,000 cash and the interest expense is $42,800*, the difference will be the amount of the premium amortization. Notice that the interest expense is LESS than the payment to the bondholders when bonds are issued at a premium. (It is just the opposite when bonds are issued at a discount.) *1,070,000 x .08 x 1/2=42,800 Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Next Time -- When we calculate the amount of interest expense for the second interest payment, our principal balance has changed. Instead of 1,070,000, we now have a principal balance of 1,067,800. Why? Because we amortized $2,200 of the premium. Now it’s only $67,800. 1,067,800 x .08 x 1/2 = $42,712 This is the interest expense for the second six-month period. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Method For Amortizing A Bond Premium The payment to the bondholders is the same each time a payment is made-- $45,000. Interest expense for the second payment is $42,712 The difference between the payment and the expense is the amount of amortization of the premium--$2,288. The new carrying value is $1,067,800 - 2,288 = $1,065,512. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Effective Interest Method For Amortizing A Bond Premium Carrying value is defined as the face value plus any unamortized premium. In this case, the premium started at 70,000 and has been reduced by 2,200 and by 2,288, for a balance of 65,512. The face of $1,000,000 plus the unamortized premium of 65,512 gives a carrying value of $1,065,512 after the second interest payment. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company What’s Happening? Each time we pay the bondholders $45,000, we are paying the full amount of the true interest expense for the $1,070,000 loan, plus some of the principal. The amount we pay in excess of the interest expense gets deducted from the carrying value of the bond. (Reducing the premium decreases the carrying value of the bond.) So, the bond’s carrying value is decreasing from $1,070,000 to the face value of $1,000,000 over the life of the bond. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Straight-Line Amortization of Bond Premium Identify the amount of the bond premium. Divide the bond premium by the number of interest periods. Include the premium amortization amount as part of the periodic interest expense entry. The premium will be reduced to zero by the maturity date. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Straight-Line Amortization of Bond Premium Interest payment is always $45,000. Premium amortization is 70,000 = 3,500. 20 That means that the premium will be amortized by 3,500 every time a payment is made. Interest expense will be $41,500 each time a payment is made. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Carrying Value Of BONDS PAYABLE While the specific long-term liability Bonds Payable is always recorded (and kept) at face value, the Discount or Premium (on Bonds Payable) will be either subtracted (discount) or added (premium) to the BP amount to get the carrying value of the bond at any given date. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Understanding Notes to Financial Statements Effective-interest method of amortization is preferred by GAAP. Straight-line amortization may be used if it is not materially different from effective interest amortization. Most companies do not disclose the method used for bond interest amortization. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Trading Bonds When a bondholder sells a bond, there is no effect on the books of the issuing company. Bondholders trade among themselves in the bond market. Changes in the market rate of interest and the risk related to specific bonds cause the prices of bonds to change. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Early Retirement of Debt: Calling a Bond Occasionally, the issuing company will call (repay early) some or all of its bonds. If the bond is callable, the issuer may decided to call the bond (retire it before maturity). The liability would be removed and any call premium would be recorded on the income statement. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Early Retirement of Debt Bonds can also be retired by purchasing the bond on the open market. Any gains or losses incurred as a result of retiring the bonds should be reported as extraordinary items on the income statement. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Copyright 2003 Prentice Hall Publishing Company Bond Sinking Funds A special fund to be used to retire bonds at maturity is a sinking fund. Normally, periodic cash contributions are made to the fund. Usually, it is reported on the balance sheet as a non-current asset. Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Debt-Equity Ratio = Total Debt ÷ Total Equity Financial Analysis The debt-equity ratio is an important measure of the state of a company’s capital structure. When a company’s debt-equity ratio is excessive, a large amount of fixed debt payments may cause problems in tight cash flow periods. Debt-Equity Ratio = Total Debt ÷ Total Equity Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company

Net income + Interest expense Financial Analysis The times-interest-earned ratio is another measure of the firm’s ability to support its level of debt. A company must be earning income in excess of its interest payments! Like all ratios, we need a basis for comparison to give meaning to this ratio. Net income + Interest expense Interest expense Copyright 2003 Prentice Hall Publishing Company Copyright 2003 Prentice Hall Publishing Company